Inventory Accounting and Valuation by Fathi SalemInventories are goods held for sale as part of a company’s normal business operations. With the exception of certain service organizations, inventories are essential and important assets of companies. We scrutinize inventories because they are a major component of operating assets and directly affect determination of income. The importance of costing methods for inventory valuation is due to their impact on net income and asset valuation. Inventory costing methods are used to allocate cost of goods available for sale (beginning inventory plus net purchases) between either cost of goods sold (an income deduction) or ending inventory (a current asset). Accordingly, assigning costs to inventory affects both income and asset measurements.The inventory equation is useful in understanding inventory flows. For a merchandising company:Beginning inventories - Net purchases - Cost of goods sold = Ending inventories. This equation highlights the flow of costs within the company. It can be expressed alternatively as shown in the graphic to the right.The costs of inventories are initially recorded on the balance sheet. As the inventories are sold, these costs are removed from the balance sheet and flow into the income statement as cost of goods sold (COGS). Costs cannot be in two places at the same time; either they remain on the balance sheet (as a future expense) or are recognized currently in the income statement and reduce profitability to match against sales revenue.An important concept in inventory accounting is the flow of costs. If all inventories acquired or manufactured during the period are sold, then COGS is equal to the cost of the goods purchased or manufactured. When inventories remain at the end of the accounting period, however, it is important to determine which inventories have been sold and which costs remain on the balance sheet. GAAP allows companies several options to determine the order in which costs are removed from the balance sheet and recognized as COGS in the income statement.

Inventory Cost FlowsTo illustrate the available cost-flow assumptions, assume that the following reflects the inventory records of a company:Inventory on January 1, Year 2 40 units @ $500 each $20,000Inventories purchased during the year 60 units @ $600 each 36,000Cost of goods available for sale 100 units $56,000Now, assume that 30 units are sold during the year at $800 each for total sales revenue of $24,000. US GAAP allows companies three options in determining which costs to match against sales:

First-in, First-out (FIFO). This method assumes that the first units purchased are the first units sold. In this case, these units are the units on hand at the beginning of the period. Under FIFO, the company’s gross profit is as follows:

Sales $24,000COGS (30 @ $500 each) 15,000Gross profit $ 9,000

Also, since $15,000 of inventory cost has been removed, the remaining inventory cost to be reported on the balance sheet at the end of the period is $41,000.

Last-In, First-Out. Under the LIFO inventory costing assumption, the last unitscpurchased are the first to be sold. Gross profit is, therefore, computed as

Sales $24,000COGS (30 @ $600 each) 18,000Gross profit $ 6,000

And since $18,000 of inventory cost has been removed from the balance sheet and reflected in COGS, $38,000 remains on the balance sheet to be reported as inventories.

Average Cost. This method assumes that the units are sold without regard to the order in which they are purchased and computes COGS and ending inventories as a simple weighted average as follows:

Sales $24,000COGS (30 @ $560 each) 16,800Gross profit $ 7,200

COGS is computed as a weighted average of the total cost of goods available forsale divided by the number of units available for sale ($56,000/100 _ $560). Endingunits reported on the balance sheet are $39,200 (70 units _ $560 per unit).

Example Let's examine the inventory of Cory's Tequila Co. (CTC) to see how the different inventory valuation methods can affect the financial analysis of a company.

What we are doing here is figuring out the ending inventory, the results of which depend on the accounting method, in order to find out what COGS is. All we've done is rearrange the above equation into the following:

Beginning Inventory + Net Purchases - Ending Inventory = Cost of Goods Sold

LIFO Ending Inventory Cost = 1,000 units X $8 each = $8,000 Remember that the last units in are sold first; therefore, we leave the oldest units for ending inventory.

FIFO Ending Inventory Cost = 1,000 units X $15 each = $15,000 Remember that the first units in (the oldest ones) are sold first; therefore, we leave the newest units for ending inventory.

Average Cost Ending Inventory = [(1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000 x 15)]/4000 units = $11.25 per unit

1,000 units X $11.25 each = $11,250 Remember that we take a weighted average of all the units in inventory.

Using the information above, we can calculate various performance and leverage ratios. Let's assume the following:

Assets (not including inventory) $150,000 Current assets (not including inventory) $100,000 Current liabilities $40,000 Total liabilities $50,000

Each inventory valuation method causes the various ratios to produce significantly different results (excluding the effects of income taxes):

Ratio LIFO FIFO Average CostDebt-to-Asset 0.32 0.30 0.31Working Capital 2.7 2.88 2.78Inventory Turnover 7.5 4.0 5.3Gross Profit Margin 38% 50% 44%

As you can see from the ratio results, inventory analysis can have a big effect on the bottom line. Unfortunately, a company probably won't publish its entire inventory situation in its financial statements. Companies are required, however, to state in the notes to financial statements what inventory system they use. By learning how these differences work, you will be better able to compare companies within the same industry.

Conclusion As a final note, many companies will also state that they use the "lower of cost or market". This means that if inventory values were to plummet, their valuations would represent the market value (or replacement cost) instead of FIFO, LIFO or average cost.

Understanding inventory calculation might seem overwhelming, but it's something you need to be aware of. Next time you're valuing a company, check out its inventory; it might reveal more than you thought.

References:

1. John J. Wild, K.R Subramanyam, Robert F. Halsey. "Financial Statement Analysis 9th Edition, Published by McGraw-Hill.

2. Investopedia Staff http://www.investopedia.com/articles/02/060502.asp